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Monday, October 1, 2012

Federal Deductibility of State and Local Taxes

Steven Maguire
Specialist in Public Finance

Under current law, taxpayers who itemize can deduct state and local real estate taxes, personal property taxes, and income taxes from federal income when calculating taxable income. In addition, a temporary deduction for sales taxes in lieu of income taxes is available, though it expires December 31, 2011. The federal deduction for state and local taxes results in the federal government paying part of these taxes through lower federal tax collections. Theory would suggest that taxpayers are willing to accept higher state and local tax rates and greater state and local public spending because of lower federal income taxes arising from the deduction. In addition, there is some evidence that state and local governments rely more on these deductible taxes than on nondeductible taxes and fees for services.

Repealing the deductibility of state and local taxes would affect state and local government fiscal decisions, albeit indirectly. Generally, state and local public spending would decline, although the magnitude of the decline is uncertain. And, repealing the deduction for state and local taxes would shift the federal tax burden away from low-tax states to high-tax states. Maintaining the current deductibility would continue the indirect federal subsidy for state/local spending.

Expanding deductibility, such as extending the sales tax deduction option or allowing nonitemizers to deduct taxes paid, would likely increase the subsidy for state and local spending. The sales tax deduction option would primarily benefit taxpayers in states without an income tax that are already itemizing. The effect of allowing non-itemizers to deduct taxes paid would depend on the type of deductible tax. For example, property taxes are only paid (directly) by property owners whereas all consumers pay sales taxes in states that levy a sales tax. P.L. 111-312, the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, extended the sales tax deduction option through the 2011 tax year.

In the 111th Congress, P.L. 111-5, the American Recovery and Reinvestment Act, provided for an above-the-line deduction for sales and excise taxes paid on new vehicle purchases for nonitemizers which has expired. The President’s FY2013 budget includes an extension of the sales tax deduction option through 2013 and proposes a limit on the tax rate (generally a 28% marginal tax rate) at which itemized deductions would reduce tax liability. In the Senate, S. 3521 would also extend the deduction through 2013, reducing revenues by $4.4 billion over the 2013 to 2022 budget window.

Date of Report: September 20, 2012
Number of Pages: 14
Order Number: RL32781
Price: $29.95

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